Simulate multivariate stochastic differential equations (SDEs)

`[Paths, Times, Z] = simulate(MDL, ...)`

All classes in the SDE Class Hierarchy.

This method simulates any vector-valued SDE of the form:

$$d{X}_{t}=F(t,{X}_{t})dt+G(t,{X}_{t})d{W}_{t}$$ | (18-9) |

where:

*X*is an*NVARS*-by-`1`

state vector of process variables (for example, short rates or equity prices) to simulate.*W*is an*NBROWNS*-by-`1`

Brownian motion vector.*F*is an*NVARS*-by-`1`

vector-valued drift-rate function.*G*is an*NVARS*-by-*NBROWNS*matrix-valued diffusion-rate function.

`[Paths, Times, Z] = simulate(MDL, ...)`

simulates `NTRIALS`

sample
paths of `NVARS`

correlated state variables, driven
by `NBROWNS`

Brownian motion sources of risk over `NPERIODS`

consecutive
observation periods, approximating continuous-time stochastic processes.

`MDL` | Stochastic differential equation model. |

The `simulate`

method accepts any variable-length
list of input arguments that the simulation method or function referenced
by the `SDE.Simulation`

parameter requires or accepts.
It passes this input list directly to the appropriate SDE simulation
method or user-defined simulation function.

`Paths` | `(NPERIODS + 1)` -by-`NVARS` -by-`NTRIALS` three-dimensional
time series array, consisting of simulated paths of correlated state
variables. For a given trial, each row of `Paths` is the
transpose of the state vector X at
time _{t}t. |

`Times` | `(NPERIODS + 1)` -by-`1` column
vector of observation times associated with the simulated paths. Each
element of `Times` is associated with a corresponding
row of `Paths` . |

`Z` | `NTIMES` -by-`NBROWNS` -by-`NTRIALS` three-dimensional
time series array of dependent random variates used to generate the
Brownian motion vector (Wiener processes) that drove the simulated
results found in `Paths` . `NTIMES` is
the number of time steps at which `simulate` samples
the state vector. `NTIMES` includes intermediate
times designed to improve accuracy, which `simulate` does
not necessarily report in the `Paths` output time
series. |

Simulation methods allow you to specify a popular *variance
reduction* technique called *antithetic sampling*.
This technique attempts to replace one sequence of random observations
with another of the same expected value, but smaller variance.

In a typical Monte Carlo simulation, each sample path is independent
and represents an independent trial. However, antithetic sampling
generates sample paths in pairs. The first path of the pair is referred
to as the *primary path*, and the second as the *antithetic
path*. Any given pair is independent of any other pair,
but the two paths within each pair are highly correlated. Antithetic
sampling literature often recommends averaging the discounted payoffs
of each pair, effectively halving the number of Monte Carlo trials.

This technique attempts to reduce variance by inducing negative dependence between paired input samples, ideally resulting in negative dependence between paired output samples. The greater the extent of negative dependence, the more effective antithetic sampling is.

This example applies antithetic sampling to a path-dependent
barrier option. Consider a European up-and-in call option on a single
underlying stock. The evolution of this stock's price is governed
by a Geometric Brownian Motion (`GBM`

) model with
constant parameters:

$$d{X}_{t}=0.05{X}_{t}dt+0.3{X}_{t}d{W}_{t}$$

Assume the following characteristics:

The stock currently trades at 105.

The stock pays no dividends.

The stock volatility is 30% per annum.

The option strike price is 100.

The option expires in three months.

The option barrier is 120.

The risk-free rate is constant at 5% per annum.

The goal is to simulate various paths of daily stock prices, and calculate the price of the barrier option as the risk-neutral sample average of the discounted terminal option payoff. Since this is a barrier option, you must also determine if and when the barrier is crossed.

This example performs antithetic sampling by explicitly setting
the `Antithetic`

flag to `true`

,
and then specifies an end-of-period processing function to record
the maximum and terminal stock prices on a path-by-path basis.

Create a

`GBM`

model using the`gbm`

constructor:barrier = 120; % barrier strike = 100; % exercise price rate = 0.05; % annualized risk-free rate sigma = 0.3; % annualized volatility nPeriods = 63; % 63 trading days dt = 1 / 252; % time increment = 252 days T = nPeriods * dt; % expiration time = 0.25 years obj = gbm(rate, sigma, 'StartState', 105);

Perform a small-scale simulation that explicitly returns two simulated paths:

rng('default') % make output reproducible [X, T] = obj.simBySolution(nPeriods, 'DeltaTime', dt, ... 'nTrials', 2, 'Antithetic', true);

Perform antithetic sampling such that all primary and antithetic paths are simulated and stored in successive matching pairs. Odd paths (1,3,5,...) correspond to the primary Gaussian paths. Even paths (2,4,6,...) are the matching antithetic paths of each pair, derived by negating the Gaussian draws of the corresponding primary (odd) path.

Verify this by examining the matching paths of the primary/antithetic pair:

plot(T, X(:,:,1), 'blue', T, X(:,:,2), 'red') xlabel('Time (Years)'), ylabel('Stock Price'), ... title('Antithetic Sampling') legend({'Primary Path' 'Antithetic Path'}, ... 'Location', 'Best')

To price the European barrier option, specify an end-of-period processing function to record the maximum and terminal stock prices. This processing function is accessible by time and state, and is implemented as a nested function with access to shared information that allows the option price and corresponding standard error to be calculated. For more information on using an end-of-period processing function, see Pricing Equity Options.

Simulate 200 paths using the processing function method:

rng('default') % make output reproducible barrier = 120; % barrier strike = 100; % exercise price rate = 0.05; % annualized risk-free rate sigma = 0.3; % annualized volatility nPeriods = 63; % 63 trading days dt = 1 / 252; % time increment = 252 days T = nPeriods * dt; % expiration time = 0.25 years obj = gbm(rate, sigma, 'StartState', 105); nPaths = 200; % # of paths = 100 sets of pairs f = Example_BarrierOption(nPeriods, nPaths); simulate(obj, nPeriods, 'DeltaTime' , dt, ... 'nTrials', nPaths, 'Antithetic', true, ... 'Processes', f.SaveMaxLast);

Approximate the option price with a 95% confidence interval:

optionPrice = f.OptionPrice (strike, rate, barrier); standardError = f.StandardError(strike, rate, barrier,... true); lowerBound = optionPrice - 1.96 * standardError; upperBound = optionPrice + 1.96 * standardError; fprintf(' Up-and-In Barrier Option Price: %8.4f\n', ... optionPrice) fprintf(' Standard Error of Price: %8.4f\n', ... standardError) fprintf(' Confidence Interval Lower Bound: %8.4f\n', ... lowerBound) fprintf(' Confidence Interval Upper Bound: %8.4f\n', ... upperBound)

Up-and-In Barrier Option Price: 6.6572 Standard Error of Price: 0.7292 Confidence Interval Lower Bound: 5.2280 Confidence Interval Upper Bound: 8.0864

Ait-Sahalia, Y., "Testing Continuous-Time Models of the
Spot Interest Rate," *The Review of Financial Studies*, Spring
1996, Vol. 9, No. 2, pp. 385–426.

Ait-Sahalia, Y., "Transition Densities for Interest Rate
and Other Nonlinear Diffusions," *The Journal of
Finance*, Vol. 54, No. 4, August 1999.

Glasserman, P., *Monte Carlo Methods in Financial
Engineering*, New York: Springer-Verlag, 2004.

Hull, J. C., *Options, Futures, and Other Derivatives*,
5th ed. Englewood Cliffs, NJ: Prentice Hall, 2002.

Johnson, N. L., S. Kotz, and N. Balakrishnan, *Continuous
Univariate Distributions*, Vol. 2, 2nd ed. New York: John
Wiley & Sons, 1995.

Shreve, S. E., *Stochastic Calculus for Finance II:
Continuous-Time Models*, New York: Springer-Verlag, 2004.

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